Who Is a Highly Compensated Employee Under 414(q)(1)(B)?

A highly compensated employee (HCE), as defined by Internal Revenue Code Section 414(q), is anyone who either owned more than 5% of the employer at any point in the current or prior year, or earned more than an indexed compensation threshold from the employer during the prior year. For 2026 plan years, that threshold is $160,000, applied to what the employee earned in 2025.¹ Job title, seniority, and management status have nothing to do with it. The label exists for one reason: to let the IRS enforce nondiscrimination rules on 401(k) and similar plans, so those plans can’t quietly funnel their tax advantages to the best-paid workers.

The Two Paths to HCE Status

Section 414(q) sets up two independent tests. Meeting either one is enough.²

The ownership test looks at whether the employee held more than 5% of the employer at any point during the current plan year or the year before. The compensation test looks at whether the employee’s pay during the prior year (the “look-back year”) cleared the indexed dollar threshold.

The look-back structure is deliberate. Because current-year HCE status turns on last year’s numbers, a plan administrator knows exactly who the HCEs are before the plan year even begins, and can run testing without waiting for year-end payroll data.

The 5% Ownership Test

The ownership prong is absolute and has no earnings floor. Hold more than 5% of the employer at any point during the current or prior year, and you are an HCE for that plan year, even at minimum wage.² For a corporation, “5%” means more than 5% of the outstanding stock or its total value. For a partnership or LLC, it means more than 5% of the capital or profits interest.

Ownership Through Family Members

An employee who personally owns nothing can still land on the wrong side of the 5% line through the constructive ownership rules of Section 318. Under those rules, stock held by a spouse, children, grandchildren, or parents is attributed to the employee.³ So if a parent owns 6% of the company and their adult child works there, the child is treated as a 5% owner and is automatically an HCE. What the child actually earns doesn’t matter.

The attribution runs through both the current year and the look-back year, so briefly moving shares out of family hands during a testing window won’t defeat the rule if family members held the stock at any other point.

The Compensation Test

The second path compares each employee’s pay during the look-back year against an indexed dollar ceiling that the IRS adjusts periodically. For 2026 plan years, the threshold is $160,000, meaning employees who earned more than $160,000 from the employer in 2025 are HCEs in 2026.⁴ That same $160,000 figure applied for 2025 plan years, based on 2024 compensation, so the number has held steady for two consecutive years.¹

What Counts as Compensation

The pay figure here is not your W-2 Box 1 number. Section 414(q) borrows the broader compensation definition from Section 415(c)(3), which sweeps in pre-tax dollars that never appear in take-home pay.² The total picks up:

All W-2 wages.
Elective deferrals into a 401(k), 403(b), or similar plan, including Roth contributions.
Pre-tax deductions for health insurance, dependent care, and other benefits taken through a Section 125 cafeteria plan.

An employee whose W-2 Box 1 reads $148,000 can still clear the $160,000 line once you add back $14,000 in 401(k) deferrals and $5,000 in pre-tax health premiums.⁵ Administrators who look only at Box 1 will misclassify people, and that error flows into every nondiscrimination test the plan runs.

The Top-Paid Group Election

Employers have an optional second filter on the compensation test. Under the top-paid group election, an employee only counts as an HCE under the compensation prong if they clear the $160,000 threshold and rank in the top 20% of the workforce by pay.²

At companies where a large share of employees earn above the threshold, this election shrinks the HCE pool and makes nondiscrimination testing easier to pass. The employer identifies the top 20% by ranking everyone by compensation and drawing the line at the 80th percentile. Certain categories (short-tenure, part-time, seasonal, under 21, nonresident aliens without U.S. earned income, and some collectively bargained employees) can be dropped from the headcount before that cutoff is calculated. The election must be applied consistently across all of the employer’s qualified plans for the plan year.

One thing the election does not do: it doesn’t change the ownership test. A more-than-5% owner is an HCE regardless of where they sit in the pay rankings.

Former Employees Still Count

HCE status doesn’t end at separation. A former employee is treated as highly compensated if they were an HCE in the year they left, or if they were an HCE at any time after reaching age 55.² Former employees who still hold plan balances are included in testing, so a retired executive with a large 401(k) can’t shed the label by leaving payroll.

Why the Classification Matters

The whole point of the HCE label is nondiscrimination testing. Federal tax law gives 401(k) and similar plans real tax advantages, but only on the condition that those advantages get shared reasonably between HCEs and non-highly compensated employees (NHCEs). Two annual tests do the policing.

The ADP and ACP Tests

The Actual Deferral Percentage (ADP) test compares the average elective deferral rate of the HCE group to the average for NHCEs. The Actual Contribution Percentage (ACP) test does the same comparison for employer matching contributions and employee after-tax contributions.⁶

A plan passes if the HCE average doesn’t exceed the greater of two limits:

125% of the NHCE average, or
The NHCE average plus 2 percentage points, but no more than double the NHCE average.

The doubling cap catches plans with very low NHCE participation. If NHCEs average 1%, HCEs are capped at 2% under the second prong (double), not 3% (1% plus 2 points). When NHCEs average 6%, the second prong lets HCEs go to 8%, well under the doubling cap of 12%.

What Happens When the Plan Fails

A failed test doesn’t disqualify the plan on the spot, but it does start a correction clock. The most common fix is distributing excess contributions back to HCEs to pull the HCE average down to a passing level. The employer can instead make qualified nonelective contributions (QNECs) to NHCEs to lift their average. Either way, if the plan sponsor doesn’t correct within 12 months after the plan year closes, the plan’s qualified status is at risk.⁶ For the individual HCE, the practical hit is a mid-year or post-year-end refund of contributions they thought were locked into the plan.

Safe Harbor Plans Skip the Testing

Many employers sidestep the whole exercise by adopting a safe harbor 401(k). In exchange for committing to specified minimum employer contributions, the plan is treated as automatically satisfying nondiscrimination requirements.⁷ HCEs in a safe harbor plan can generally defer up to the full annual limit without worrying about refunds.

Safe harbor contributions come in three standard forms: a basic match (100% on the first 3% deferred, plus 50% on the next 2%), an enhanced match at least as generous at every tier (commonly dollar-for-dollar on the first 4%), or a nonelective contribution of at least 3% of pay for every eligible employee whether they defer or not. Safe harbor contributions must vest immediately, with a narrow exception for certain QACA designs that allow up to two-year vesting.

If you find out you’re an HCE, nothing in the tax code changes what you’re allowed to defer. What changes is the risk that your plan’s testing will force part of your contribution back out to you. In a traditional plan, watching the NHCE participation rate (and pushing to raise it) is the practical protection. In a safe harbor plan, the testing risk is gone, and being an HCE is largely a label with no consequence to your own contributions.

1
Internal Revenue Service. Amounts Relating to Retirement Plans and IRAs, as Adjusted for Changes in Cost-of-Living
2
Office of the Law Revision Counsel. 26 USC 414 – Definitions and Special Rules
3
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
4
Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
5
Office of the Law Revision Counsel. 26 USC 415 – Limitations on Benefits and Contribution Under Qualified Plans
6
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Failed the 401(k) ADP and ACP Nondiscrimination Tests
7
Internal Revenue Service. 401(k) Plan Fix-It Guide – The Plan Does Not Satisfy the 401(k) Nondiscrimination Testing Requirements